Comparison Between Latin America Debt Crisis and Recent US Crisis

Akash Gupta : 2011021 Aman Saxena : 2011027 Anant Kharad : 2011031 Anchal Jain : 2011033 Anumita Chakrabarti: 2011041 Upasana Gupta : 2011210

1. Introduction
1.1 Financial Crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth; they do not directly result in changes in the real economy unless a recession or depression follows. Many economists have offered theories about how financial crises develop and how they could be prevented. There is little consensus, however, and financial crises are still a regular occurrence around the world.

1.2 Types of Financial Crisis

Banking crisis- When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run. Since banks lend out most of the cash they receive in deposits (see fractional-reserve banking), it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run may leave the bank in bankruptcy, causing many depositors to lose their savings unless they are covered by deposit insurance. A situation in which bank runs are widespread is called a systemic banking crisis or just a banking panic. A situation without widespread bank runs, but in which banks are reluctant to lend, because they worry that they have insufficient funds available, is often called a credit crunch. In this way, the banks become an accelerator of a financial crisis.

Examples of bank runs include the run on the Bank of the United States in 1931 and the run on Northern Rock in 2007. The collapse of Bear Stearns in 2008 has also sometimes been called a bank run, even though Bear Stearns was an investment bank rather than a commercial bank. Banking crises generally occur after periods of risky lending and heightened loan defaults. The U.S. savings and loan crisis of the 1980s led to a credit crunch which is seen as a major factor in the U.S. recession of 199091.Speculative bubbles and crashesEconomists say that a financial asset (stock, for example) exhibits a bubble when its price exceeds the present value of the future income (such as interest or dividends) that would be received by owning it to maturity. If most market participants buy the asset primarily in hopes of selling it later at a higher price, instead of buying it for the income it will generate, this could be evidence that a bubble is present. If there is a bubble, there is also a risk of a crash in asset prices: market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall. However, it is difficult to tell in practice whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles reliably. Some economists insist that bubbles never or almost never occur.

Black Friday, 9 May 1873, Vienna Stock Exchange. The Panic of 1873 and Long Depression followed.

Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and other asset prices include the Dutch tulip mania, the Wall Street Crash of 1929, the Japanese property bubble of the 1980s, the crash of the dot-com bubble in 20002001, and the now-deflating United States housing bubble.
International financial crises-When a country that maintains a fixed exchange rate is suddenly forced to devalue its currency because of a speculative attack, this is called a currency crisis or balance of payments crisis. When a country fails to pay back its sovereign debt, this is called a sovereign default. While devaluation and default could both be voluntary decisions of the government, they are often perceived to be the involuntary results of a change in investor sentiment that leads to a sudden stop in capital inflows or a sudden increase in capital flight.

Several currencies that formed part of the European Exchange Rate Mechanism suffered crises in 199293 and were forced to devalue or withdraw from the mechanism. Another round of currency crises took place in Asia in 199798. Many Latin American countries defaulted on their debt in the early 1980s. The 1998 Russian financial crisis resulted in a devaluation of the ruble and default on Russian government bonds.
Wider economic crises

Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged recession may be called a depression, while a long period of slow but not necessarily negative growth is sometimes called economic stagnation. Since these phenomena affect much more than the financial system they are not usually considered financial crises as such though there are clearly links between the two. Some economists argue that many recessions have been caused in large part by financial crises. One important example is the Great Depression, which was preceded in many countries by bank runs and stock market crashes. The subprime mortgage crisis and the bursting of other real estate bubbles around the world also led to recession in the U.S. and a number of other countries in late 2008 and 2009. Some economists argue that financial crises are caused by recessions instead of the other way around, and that even where a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession. In particular, Milton Friedman and Anna Schwartz argued that the initial economic decline associated with the crash of 1929 and the bank panics of the 1930s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve, a position supported by Ben Bernanke.

2. Latin American Crisis

The Latin American debt crisis was a financial crisis that occurred in the early 1980s (and for some countries starting in the 1970s), often known as the "lost decade", when Latin American countries reached a point where their foreign debt exceeded their earning power and they were not able to repay it.

2.1 Origin
In the 1960s and 1970s many Latin American countries, notably Brazil, Argentina, and Mexico, borrowed huge sums of money from international creditors for industrialization; especially infrastructure programs. These countries had soaring economies at the time so the creditors were happy to continue to provide loans. Initially, developing countries typically garnered loans through public routes like the World Bank. After 1973, private banks had an influx of funds from oil-rich countries and believed that sovereign debt was a safe investment. Between 1975 and 1982, Latin American debt to commercial banks increased at a cumulative annual rate of 20.4 percent. This heightened borrowing led Latin America to quadruple its external debt from $75 billion in 1975 to more than $315 billion in 1983, or 50 percent of the region's gross domestic product (GDP). Debt service (interest payments and the repayment of principal) grew even faster, reaching $66 billion in 1982, up from $12 billion in 1975.

2.2 Begging of the crisis

When the world economy went into recession in the 1970s and 80s, and oil prices skyrocketed, it created a breaking point for most countries in the region. Developing countries also found themselves in a desperate liquidity crunch. Petroleum exporting countries flush with cash after the oil price increases of 1973-74 invested their money with international banks, which 'recycled' a major portion of the capital as loans to Latin American governments. The sharp increase in oil prices caused many countries to search out more loans to cover the high prices, and even oil producing countries wanted to use the opportunity to develop further. These oil producers believed that the high prices would remain and would allow them to pay off their additional debt. As interest rates increased in the United States of America and in Europe in 1979, debt payments also increased, making it harder for borrowing countries to pay back their debts.[3] Deterioration in the exchange rate with the US dollar meant that Latin American governments ended up owing tremendous quantities of their national currencies, as well as losing purchasing power. The contraction of world trade in 1981 caused the prices of primary resources (Latin America's largest export) to fall. While the dangerous accumulation of foreign debt occurred over a number of years, the debt crisis began when the international capital markets became aware that Latin America would not be able to pay back its loans. This occurred in August 1982 when

Mexico's Finance Minister, Jesus Silva-Herzog declared that Mexico would no longer be able to service its debt. Mexico declared that it couldn't meet its payment due-dates, and announced unilaterally, a moratorium of 90 days; it also requested a renegotiation of payment periods and new loans in order to fulfil its prior obligations. In the wake of Mexico's default, most commercial banks reduced significantly or halted new lending to Latin America. As much of Latin America's loans were short-term, a crisis ensued when their refinancing was refused. Billions of dollars of loans that previously would have been refinanced, were now due immediately. The banks had to somehow restructure the debts to avoid financial panic; these usually involved new loans with very strict conditions, as well as the requirement that the debtor countries accept the intervention of the International Monetary Fund (IMF). There were several stages of strategies to slow and end the crisis. The IMF moved to restructure the payments and reduce consumption in debtor countries. Later it and the World Bank encouraged opened markets. Finally, the US and the IMF pushed for debt relief, recognizing that countries would not be able to pay back in full the large sums they owed.

2.3 Effects of Latin American Debt Crisis and the IMF

Since Latin American countries, such as Mexico and Brazil, were not able to pay back their foreign debts, it showed that Latin America is not able to keep up with the pace in which their debts grew. Before the crisis, Brazil and Mexico tried to borrow money to enhance economic stability and reduce the poverty rate. But after continuously borrowing money, they fell in the whirlpool of debt, and the innovations and improvements from the past few years became meaningless. During the 1970s the world fell into an international recession which strained and put stress onto the economies of countries all over the world. Many major nations and countries attempted to slow down and stop inflation in their countries by raising the interest rates of the money that they loaned, causing Latin Americas already enormous debt to increase further. In between the years of 1970 to 1980, Latin Americas debt levels increased by more than onethousand percent. The crisis caused the per capita income to drop and also ironically increased poverty as the gap between the wealthy and poor increased dramatically. Due to the plummeting employment rate, children and young adults were forced to join the drug trade, and some even began prostitution. The low employment rate also caused many problems like homicides and crime and made the affected countries undesirable places to live. Frantically trying to solve these problems, debtor countries felt pressured to constantly pay back the money that they owed, which made it hard to rebuild an economy already in ruins. Latin America, unable to pay their debts, turned to the IMF (International Monetary Fund) who provided money for loans and unpaid debts. In return, the IMF forced Latin America to make reforms that would favour free-market capitalism. These reforms helped Latin America evade a dangerously close encounter with a country wide depression. The IMF also helped Latin America utilize austerity plans and programs that will lower total spending in an effort to recover from the debt crisis. The efforts of the

IMF brought Latin Americas economy to become a capitalist free-trade type of economy which is a type of economy preferred by wealthy and fully developed countries. Despite all of the good deeds the IMF has done, Latin Americas growth rate fell dramatically due to the governments austerity plans which prevented them from further spending. The living standards also fell alongside the growth rate which caused much anger and hatred from the people towards the IMF. This caused the IMF to become a symbol that people came to dislike as more and more people began to reject the IMFs policies which imposed the power of international agencies over Latin America. The citizens of Latin America did not like the fact that their government was being controlled by outsiders. Leaders and officials were ridiculed and some even discharged due to involvement and defending of the IMF. In the late 1980s Brazilian officials planned a debt negotiation meeting where they decided to never again sign agreements with the IMF. The efforts of the IMF helped Latin America regain some balance after the debt crisis but was not able to resolve all of its issues.

2.4 Current levels of external debt

Since the 1980 several countries in the region have experienced a surge in economic development and have initiated debt management programs in addition to debt relief and debt rescheduling programs agreed to by their international creditors. The following is a list of external debt for Latin America based on a March 2006 report by The World Factbook:
Rank Country - Entity 22 24 29 39 43 45 50 65 73 79 81 85 88 95 98 Brazil Mexico Argentina Chile Venezuela Colombia Peru Ecuador Cuba Uruguay Panama El Salvador Bolivia Guatemala External Debt Date of information (million US$) 211,400 274,800 119,000 44,800 39,790 37,060 30,180 17,010 13,100 9,931 9,859 8,273 6,430 5,503 4,675 4,054 3,633 3,535 30 June 2005 est. 30 June 2011 est June 2005 est. 31 October 2005 est. 2005 est. 30 June 2005 est. 30 June 2005 est. 31 December 2004 est. 2005 est. 30 June 2005 est. 2005 est. 30 June 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 2005 est. 30 June 2005 est. 2005 est.

Dominican Republic 7,907

103 Honduras 108 Nicaragua 110 Costa Rica 112 Paraguay